Acemoglu, Robinson, and Verdier say the model might help us understand patterns
of economic growth and well-being in the United States and the Nordic countries
— Denmark, Finland, Norway, and Sweden. The United States chose cutthroat
capitalism, while the Nordics chose cuddly capitalism. The U.S. grew faster for
a short time, but since then all five countries have grown at the roughly same
pace. America’s high inequality encourages innovation. The Nordics can be cuddly
and still grow rapidly because of technological spillover. If the U.S. were to
decide to go cuddly, innovation would slow. Both sets of nations would grow less
rapidly. ...

Will American innovation slow if we go “cuddly”?

The really interesting question posed by Acemoglu, Robinson, and Verdier is
whether innovation would slow in the United States if we strengthened our safety
net and/or reduced the relative financial payoff to entrepreneurial success. I’m
skeptical, for three reasons.

The first flows from America’s past experience. According to Acemoglu et al’s
logic, incentives for innovation in the U.S. were weakest in the 1960s and
1970s. In 1960 the top 1%’s share of pretax income had been falling steadily for
several decades and had nearly reached its low point. Government spending,
meanwhile, had been rising steadily and was close to its peak level. Yet there
was plenty of innovation in the 1960s and 1970s, including notable advances in
computers, medical technology, and others.

Second, the Nordic countries, with their low income inequality and generous
safety nets, currently are among the world’s most innovative countries. The
World Economic Forum’s
Global Competitiveness Index has consistently ranked them close to the
United States in innovation. The most recent report, for 2012-13, rates Sweden
as the world’s most innovative nation, followed by Finland. The U.S. ranks
sixth. The 2012 WIPO-Insead
Global
Innovation Index ranks Sweden second and the United States tenth. Whether or
not this lasts, it suggests reason to doubt that modest inequality and generous
cushions are significant obstacles to innovation.

Third, if Acemoglu and colleagues are correct about the value of financial
incentives in spurring innovation, we should see this reflected not only in the
United States but also in other nations with relatively high income inequality
and low-to-moderate government spending, such as Australia, Canada, Ireland, New
Zealand, and the United Kingdom. But we don’t. ...

There’s one additional possibility worth considering. If financial incentives
truly are critical for spurring innovation, it could be the opportunity for
large gains that matters, rather than the absence of cushions. Suppose we were
to increase government revenues in the United States via higher taxes on
everyone — steeper income taxes on the top 1% or 5% plus a new national
consumption tax. And imagine we used those revenues to expand public insurance
and services — fully universal health insurance, universal early education, a
beefed-up Earned Income Tax Credit, a new wage insurance program, more
individualized assistance with training and job placement. These changes
wouldn’t alter income inequality much, but they would enhance economic security
and opportunity. Would innovation decline? I doubt it. ...

An enhanced safety net -- a backup if things go wrong -- can give people the security they need to take a
chance on pursuing an innovative idea that might die otherwise, or opening a
small business. So it may be that an expanded social safety net encourages
innovation.

As for the effect of reducing the financial payoff by raising taxes on high incomes to support an expansion in the safety net, I don't think it's any secret that I think the distribution of income in recent decades has pushed too much income toward the top and too little toward the middle and bottom (relative to changes in productivity). That is, the distribution of income is distorted. To the extent that taxing high incomes removes these distortions, it's helpful rather than harmful.

And there must be diminishing returns to incentives in any case. If we take away $50 million in taxes leaving someone the prospect of earning "only" $100 million in net profit (i.e. taxes are 33%), would the person really decide to give up the project? Would someone really decide it isn't worth it to only earn $100 million and work less or give it up altogether? Or is it the case that by the time you get to that much income, a marginal increase of decrease in profit has almost no effect on incentives? I'd guess that's the case (and for those in the game simply to see who can accumulate the most, so long as the rules are the same for all, incentives won't change either). There could be an effect at the margin, i.e. profitable projects become unprofitable due to the increase in the tax rate, and that could impact innovation and growth. But growth doesn't seem to decline when taxes at the top are higher, so this case is hard to make.

Acemoglu, Robinson, and Verdier say the model might help us understand patterns
of economic growth and well-being in the United States and the Nordic countries
— Denmark, Finland, Norway, and Sweden. The United States chose cutthroat
capitalism, while the Nordics chose cuddly capitalism. The U.S. grew faster for
a short time, but since then all five countries have grown at the roughly same
pace. America’s high inequality encourages innovation. The Nordics can be cuddly
and still grow rapidly because of technological spillover. If the U.S. were to
decide to go cuddly, innovation would slow. Both sets of nations would grow less
rapidly. ...

Will American innovation slow if we go “cuddly”?

The really interesting question posed by Acemoglu, Robinson, and Verdier is
whether innovation would slow in the United States if we strengthened our safety
net and/or reduced the relative financial payoff to entrepreneurial success. I’m
skeptical, for three reasons.

The first flows from America’s past experience. According to Acemoglu et al’s
logic, incentives for innovation in the U.S. were weakest in the 1960s and
1970s. In 1960 the top 1%’s share of pretax income had been falling steadily for
several decades and had nearly reached its low point. Government spending,
meanwhile, had been rising steadily and was close to its peak level. Yet there
was plenty of innovation in the 1960s and 1970s, including notable advances in
computers, medical technology, and others.

Second, the Nordic countries, with their low income inequality and generous
safety nets, currently are among the world’s most innovative countries. The
World Economic Forum’s
Global Competitiveness Index has consistently ranked them close to the
United States in innovation. The most recent report, for 2012-13, rates Sweden
as the world’s most innovative nation, followed by Finland. The U.S. ranks
sixth. The 2012 WIPO-Insead
Global
Innovation Index ranks Sweden second and the United States tenth. Whether or
not this lasts, it suggests reason to doubt that modest inequality and generous
cushions are significant obstacles to innovation.

Third, if Acemoglu and colleagues are correct about the value of financial
incentives in spurring innovation, we should see this reflected not only in the
United States but also in other nations with relatively high income inequality
and low-to-moderate government spending, such as Australia, Canada, Ireland, New
Zealand, and the United Kingdom. But we don’t. ...

There’s one additional possibility worth considering. If financial incentives
truly are critical for spurring innovation, it could be the opportunity for
large gains that matters, rather than the absence of cushions. Suppose we were
to increase government revenues in the United States via higher taxes on
everyone — steeper income taxes on the top 1% or 5% plus a new national
consumption tax. And imagine we used those revenues to expand public insurance
and services — fully universal health insurance, universal early education, a
beefed-up Earned Income Tax Credit, a new wage insurance program, more
individualized assistance with training and job placement. These changes
wouldn’t alter income inequality much, but they would enhance economic security
and opportunity. Would innovation decline? I doubt it. ...

An enhanced safety net -- a backup if things go wrong -- can give people the security they need to take a
chance on pursuing an innovative idea that might die otherwise, or opening a
small business. So it may be that an expanded social safety net encourages
innovation.

As for the effect of reducing the financial payoff by raising taxes on high incomes to support an expansion in the safety net, I don't think it's any secret that I think the distribution of income in recent decades has pushed too much income toward the top and too little toward the middle and bottom (relative to changes in productivity). That is, the distribution of income is distorted. To the extent that taxing high incomes removes these distortions, it's helpful rather than harmful.

And there must be diminishing returns to incentives in any case. If we take away $50 million in taxes leaving someone the prospect of earning "only" $100 million in net profit (i.e. taxes are 33%), would the person really decide to give up the project? Would someone really decide it isn't worth it to only earn $100 million and work less or give it up altogether? Or is it the case that by the time you get to that much income, a marginal increase of decrease in profit has almost no effect on incentives? I'd guess that's the case (and for those in the game simply to see who can accumulate the most, so long as the rules are the same for all, incentives won't change either). There could be an effect at the margin, i.e. profitable projects become unprofitable due to the increase in the tax rate, and that could impact innovation and growth. But growth doesn't seem to decline when taxes at the top are higher, so this case is hard to make.